Behavioral investing gains traction
Fri, Jul 23 2010
By John McCrank
TORONTO (Reuters) - Irrational reactions to the market chaos in recent years have led many investors to get an old market truism backwards: they've been buying high and selling low, and one result has been much more cynicism toward financial advisers.
To steady the ship, so to speak, many wealth management firms have embraced behavioral investing, which aims to eliminate emotions from investment choices. When the market meltdown was at its worst, many investors panicked and moved from equities to cash. After seeing great swaths of their wealth wiped out, they sat on the sidelines as the market rebounded, only buying back in when the opportunity for bargains was gone.
Then the Dow dropped another few hundred points, and the masses surged for the exit once more.
"Everybody has behavioral biases that will get in the way of them making smart decisions unless they actively take steps to avoid it," said Adam Butler, a director of wealth management, and portfolio manager, with the Butler|Philbrick and Associates practice at Richardson GMP.
He said behavioral investing counters some of the problems of modern portfolio theory (MPT), which says that humans are always rational and will always make the right decisions to maximize wealth.
"Behavioral investing attempts to define how people actually behave as opposed to how they are assumed to behave in MPT," he said. From there, the process seeks to gauge investors' tolerance to risk and eliminate or reduce decisions that are based more on fear, or excess optimism, than on logic.
Butler's systems rely on quantitative data to identify trends early on and to identify when the trends have likely ended, which he said has helped his team to get better returns for clients than just a simple buy and hold strategy.
"Our systems have been validated in real time with existing portfolios and additionally, the systems that we use have been validated using data going back to 1973 and in fact, with one of our systems, going back to 1870."
"If we find that investors operate under a herd mentality, which is in fact what we see experimentally, then why don't we identify early on where the herd is going and position ourselves to ride those waves?"
Butler said people are about 2.5 times as sensitive to taking losses as opposed to gains, which often causes them to optimistically hold on to losing positions well past any reasonably expiry date, and to cash in winning positions too quickly.
He said the key is to have risk management processes in place before a position is purchased that can "short-circuit" behavioral biases, so that when the numbers say it's time to get out, there is no second guessing.
When dealing with new clients, Butler has them bring in their portfolios from their previous advisers.
"What we often find are a bunch of positions on the statement that have been there for a very long time, that are down a lot and that nobody has ever taken the initiative of selling in order to move into more prospective opportunities."
In its recent 2010 Global Wealth Report, Bank of America Corp's Merrill Lynch Wealth Management said that "while behavioral finance has not been widely integrated into wealth management to date, it is gaining momentum as firms seek to navigate the new challenges in the investing environment."
It said that as part of the approach, firms were looking to help clients identify their true risk tolerance by more deeply trying to understand the investor's overall goals.
Butler said he thinks that means that big firms are beginning to realize that the risk that people say they are able to tolerate when markets are calm, changes dramatically when markets go haywire, and that puts investors in a position to make bad choices.
The solution? "Avoid putting investors in a position where they are likely to make poor, emotionally based choices," he said.
"Our systems took us to about an 85 percent cash level by the end of May, and so at the end of July, we will re-evaluate and see what the systems tell us.
"We don't act inter-month, because the volatility is just too high in that time frame."
(Reporting by John McCrank; editing by Rob Wilson)
